Capital Markets: Observations & Insights
Searching for Yield and Asking for Trouble?
Capital Markets: Observations and Insights Searching for Yield and Asking for Trouble? As of June 30, 2016
Key Observations
• Strong bond performance has supported bond-like equities and hurt growth stocks
• Fundamentals for growth equities continue to be very strong relative to value stocks
• Valuation of growth stocks are very appealing relative to bond-like equities
• A framework for evaluating future returns leads us to be more optimistic on the long-term potential for growth-oriented equities
Page 2
Asset Class Performance 2Q16 Review
• Commodities bounced back and the dollar declined, helping boost emerging markets, and when combined with the large rally in bonds, drove outperformance in value stocks
Source: FactSet as of 06/30/2016.
Page 3
Sector Performance 2Q16 Review
• Lower interest rates helped drive outperformance in defensive, bond-like sectors (highlighted below)
YTD S&P 500 Sector Performance (%)
Q216 S&P 500 Sector Performance (%)
24.8
23.4
11.6
16.1
7.1 6.8
6.3
10.5
4.6
7.5
3.7
6.5
2.1
1.4
0.7 0.4
-0.3
-0.9
-3.0
-2.8
Energy
Utilities
Telecom
Energy
Utilities
Materials
Financials
Telecom
Industrials
Materials
Financials
Industrials
Health Care
Health Care
Info Technology
Consumer Discr
Info Technology
Consumer Discr
Consumer Staples
Consumer Staples
Source: FactSet as of 06/30/2016.
Page 4
Factor Performance 2Q16 Review
• The most dominant factor for stock performance has been dividend yield as investors focus on bond-like equity characteristics rather than fundamentals
5.7
2Q16 Excess Return (%)
YTD Excess Return (%)
2.4
0.9
0.8
1.0
0.1
-0.2
-0.1 -0.1
-0.5
-0.3
-0.9 -0.9
-0.6
-1.9
-2.5
-1.3 -1.4
-3.0 -3.0
-3.4
Book/Price
Book/Price
Debt/Equity
Debt/Equity
Price Volatility
Dividend Yield
Price Volatility
Earnings/Price
Revenue/Price
Dividend Yield
Earnings/Price
Revenue/Price
Trading Activity
Trading Activity
Relative Strength
Relative Strength
EPS Growth Rate
EPS Growth Rate
Log of Market Cap
Log of Market Cap
Earnings Variability
Earnings Variability
Source: FactSet as of 06/30/16 using Northfield defined quantitative factors for the Northfield broad U.S. market database.
Page 5
Bond Yields Are Extremely Low Searching For Yield
• U.S. bond yields recently hit their lowest level on record and, generally, global interest rates are at their lowest level in 5,000 years!* ‒ $11 trillion of global government debt currently yields less than 0%. Investors are paying to lend their money!
16
10-Year Government Bond Yields
14
U.S.
China
Japan
Germany
12
U.K.
Canada
Australia
S. Korea
10
8
6
4
2
0
-2
Jul-88
Jul-99
Jul-10
Oct-85
Apr-91
Oct-96
Apr-02
Oct-07
Apr-13
Jan-83
Jun-89
Jan-94
Jun-00
Jan-05
Jun-11
Jan-16
Mar-92
Mar-03
Mar-14
Feb-93
Feb-04
Feb-15
Dec-83
Nov-84
Dec-94
Nov-95
Dec-05
Nov-06
Sep-86
Aug-87
Sep-97
Aug-98
Sep-08
Aug-09
May-90
May-01
May-12
Source: FactSet. *Bank of England, Global Financial Data, Homer and Sylla “A History of Interest Rates,” and BofA Merrill Lynch.
Page 6
Asset Flows Continue to Chase Income Searching For Yield
• The search for yield is apparent in equity fund flows—equity income funds have seen modest inflows compared to large outflows for equity growth funds
• Investors have poured money into bond funds and redeemed from equity funds
YTD Fund Flows ($m)
YTD Fund Flows ($m)
80,000
10,000
65,205
616
40,000
(10,000)
-
(30,000)
(40,000)
(43,752)
(40,894)
(80,000)
(50,000)
Bonds
Equities
Equity Income
Equity Growth
Source: Morningstar through May 2016. Bonds include taxable & municipal, and equities are the U.S. equity category. Equity income and growth based on prospectus objective.
Page 7
The Trouble With Passive Searching For Yield
• Weightings in bond-like equities have been rising recently
• The vast majority of passive investing allows relative performance to drive relative weighting changes, irrespective of fundamentals ‒ This can exacerbate bubbles, such as in tech in the late 1990s
‒ These increased weightings along with high—and rising—valuations may elevate the risk of passive investments
S&P 500 Technology Sector
S&P 500 Bond-Like Equities
Weight
Rel Perf
Weight
Rel Perf
40%
300
22%
120
115
30%
200
20%
110
20%
105
100
18%
100
10%
95
0%
-
16%
90
Jul-96
Jul-03
Apr-98
Oct-01
Apr-05
Apr-14
Oct-14
Apr-15
Oct-15
Apr-16
Jun-99
Jan-00
Jun-14
Jun-15
Jun-16
Feb-97
Mar-01
Feb-04
Feb-14
Feb-15
Feb-16
Dec-95
Nov-98
Dec-02
Nov-05
Sep-97
Aug-00
Sep-04
Dec-13
Dec-14
Dec-15
Aug-14
Aug-15
May-02
Source: FactSet. Bond like equities include consumer staples, telecommunications, utilities, and real estate.
Page 8
Equities Are Inexpensive Relative to Bonds Searching For Yield
• Will TINA * drive the stock market?
‒ The earnings yield for equities is 455 bps more than Treasury bonds
‒ The median yield spread over the past 50 years has been less than 50bps
S&P 500 EPS Yield
Treasury Bond Yield
16
14
12
10
8
6
4
455 bps
2
0
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
Source: FactSet, Federal Reserve, S&P as of 6/30/16. * TINA is an acronym for There is No Alternative [to stocks]
Page 9
Total Yield Compelling Growth vs. Bond-like Equities
• Total Yield is the highest relative to corporate bonds in two decades
• Dividends + Share Repurchases = Total Yield
S&P 500 Dividend Yield S&P 500 Buyback Yield
Total Yield
S&P 500 Total Yield
Corporate Bond Yield
8%
12%
7%
Total Yield 5.5%
10%
6%
5%
8%
4%
Share Repo. 3.3%
6%
3%
4%
2%
Dividends 2.1%
Highest Spread
2%
1%
0%
0%
Apr-96
Apr-97
Apr-98
Apr-99
Apr-00
Apr-01
Apr-02
Apr-03
Apr-04
Apr-05
Apr-06
Apr-07
Apr-08
Apr-09
Apr-10
Apr-11
Apr-12
Apr-13
Apr-14
Apr-15
Apr-16
Apr-96
Apr-97
Apr-98
Apr-99
Apr-00
Apr-01
Apr-02
Apr-03
Apr-04
Apr-05
Apr-06
Apr-07
Apr-08
Apr-09
Apr-10
Apr-11
Apr-12
Apr-13
Apr-14
Apr-15
Apr-16
Source: FactSet and Alger estimates as of 6/30/16. Corporate Bond Yield is Moody's Baa Corporate Bond Yield.
Page 10
Growth Is Where the Yield Is Growth vs. Bond-like Equities
• Growth has attractive total yields relative to traditional dividend yield sectors, which demonstrates shareholders are getting significant return of capital
High share repurchases drive higher total yield for some growth sectors.
Traditional dividend sectors have relatively low total yields despite high dividend yields.
7%
6.5%
Share Repurchases
6.0%
6%
Dividend Yield
4.9%
4.7%
5%
Total Yield
X.X%
4.3%
3.9%
4%
3%
Yield
2%
1%
0%
Technology Cons. Disc. HeathCare
Telecom Utilities Energy
Source: FactSet. Total yield is dividend yield plus share repurchase yield. Share repurchase yield is last 12 month share repurchase through April 2016 divided by shares outstanding, and dividend yield is based on 06/30/16 yield.
Page 11
Growth Sectors Are the Cheapest to Bond-like Equities in 20 Years! Growth vs. Bond-like Equities
• Bond-like stocks, such as Utilities and Consumer Staples, are expensive compared to their historic averages
Overvalued Bond-Like Equities
32.0%
28.0%
Widest Spread in 20 Years!
24.0%
20.0%
16.0%
Undervalued Growth Sectors
12.0%
8.0%
4.0%
0.0%
P/E Relative to 20-Year Median
-4.0%
-8.0%
-12.0%
Utilities Consumer Staples
Materials Financials Telecom Industrials Consumer Disc.
Health Care
Technology
Source: FactSet, June 30, 2016. Note: energy P/E is very high relative to history and not meaningful.
Page 12
Large Cap Growth is Inexpensive Relative to Large Cap Value Growth vs. Bond-like Equities
• Large cap growth has historically been at a ~40% P/E premium to large cap value but it is now only a 16% premium • Russell 1000 Growth is trading at P/E-to-growth of 1.4x vs. the Russell 1000 Value at 2.5x, which is the largest gap in over a decade
Russell 1000 Growth vs. Russell 1000 Value P/E NTM
2.40
2.20
Median ~40% Premium
2.00
1.80
1.60
Current 16% Premium
1.40
1.20
1.00
Jan-79
Jan-81
Jan-83
Jan-85
Jan-87
Jan-89
Jan-91
Jan-93
Jan-95
Jan-97
Jan-99
Jan-01
Jan-03
Jan-05
Jan-07
Jan-09
Jan-11
Jan-13
Jan-15
Source: FactSet, Bank of America as of 06/30/2016.
Page 13
Growth Stocks Have Better Fundamentals Growth vs. Bond-like Equities
• Sales estimates for R1000G stocks are rising while they are falling for the R1000V
• The long-term expected growth rate of the Russell 1000 Growth is more than double that of the Russell 1000 Value
Long-Term EPS Growth
3-Month Sales Estimate Revision
R1000G R1000V
R1000G R1000V
13.4%
0.4%
6.4%
-1.1%
Source: FactSet, June 30, 2016. The long-term expected growth rate represents a consensus estimate as reported by FactSet and does not represent a prediction or forecast by Fred Alger Management, Inc. Actual growth rates might be materially different than those shown. The 3 Month Sales Est Chg is consensus reported by FactSet and refers to 2017 sales.
Page 14
Newer Innovations Are Diffusing through Society Faster Growth vs. Bond-like Equities
• The faster speed of innovation may be exacerbating the disparity in growth rates between the R1000G and the R1000V
• Innovations are penetrating U.S. markets at an even faster pace
Years from Market Entry to 50% Penetration in the U.S.
120 160 200
0 40 80
TV - 1936
PC - 1974
VCR - 1965
ATM - 1969
Stove - 1750
Radio - 1897
Roads - 1880
Internet - 1989
Dishwasher - 1924 Air Con. - 1933
Railroad - 1830
Hospitals - 1776
Cable TV - 1950
Wash. Mach. - 1904 Air Travel - 1914
Telephone - 1880
Microwave - 1967
Steam ship - 1810
Newspaper - 1704
Credit Card - 1950
MP3 Player - 1998
Smartphone - 1996
Social Media - 2004
Second. Sch. - 1810
Electric power - 1882
Source: Asymco
Page 15
Growth through Cycles Growth vs. Bond-like Equities
• Growth fundamentals have often done quite well in difficult economic conditions
‒ During the recent Financial Crisis, U.S. retail trade was flat while innovative industries such as e-commerce and Internet advertising both grew over 30%
U.S. Internet Ad Revenue
U.S. E-Commerce
U.S. Total Retail Trade
140
130
120
Average of +30% growth during crisis time period
110
100
90
80
Q208
Q308
Q408
Q109
Q209
Q309
Q409
Q110
Q210
Q310
Q410
Q111
Q211
Source: Bureau of Economic Analysis, PwC, Census Bureau
Page 16
Prospective Returns Appear to Favor Growth Growth vs. Bond-like Equities
• Stock returns are generally the result of 1) dividend yield, 2) EPS growth, and 3) change in P/E
• Growth sectors have significant return potential relative to bond-like sectors
Framework for Estimating S&P 500 Sector Returns
EPS Growth (3-5 year consensus, reduced by 20%)
+
=
+
Dividend Yield (last 12 months)
P/E Change (20-year median P/E)
Five-Year Return (hypothetical)
Bond-Like Sectors
Utilities
4%
4%
-5%
Underperformance?
Consumer Staples
3%
7%
-5%
Underperformance?
Growth Sectors
Technology
2%
10%
2%
Outperformance?
Health Care
2%
8%
2%
Outperformance?
Consumer Discretionary
2%
14%
2%
Outperformance?
Source: FactSet, June 30, 2016. Table contains annualized S&P 500 GICS sector data. Figures for the EPS Growth represent consensus long-term analyst estimates, and actual future EPS Growth rates might be materially different than the forecasts shown. P/E assumes reversion to 20-year historic norm, and actual future P/E change may be materially different than the forecasts shown.
Page 17
Income from Growth Growth vs. Bond-like Equities
• Investors can generate income from growth if future rates of return are similar to the past
• Hypothetically, withdrawing 4% annually from $100,000 invested in the Russell 3000 Growth over the past 30 years would have generated both income and growth
Illustration of Hypothetical $100,000 Investment in Russell 3000 Growth (1986-2015)
$900,000
$845,405
$800,000
$700,000
$371,148 Income Received
$600,000
$500,000
$400,000
$300,000
$474,256 Growth in Initial Investment
$200,000
$100,000
$100,000
$0
Initial Investment 1986
2015
Source: Morningstar and Alger estimates 1/1/1986-12/31/2015. Index performance does not reflect deduction of fees, expenses or taxes. Numbers may not total due to rounding. Please note the amount of investment growth presented is provided for illustrative purposes and assumes that no other withdrawals were made aside from the annual $4,000 withdrawal during the period from January 1986 to December 2015. Such returns shown represent that of the Russell 3000 Growth Index and not actual performance of any account advised by Fred Alger Management, Inc. Investors cannot invest directly in an index, which does not assess fees and expenses that would have the effect of reducing returns. Also note that index performance reflects the reinvestment of dividends.
Page 18
Summary
• Strong bond performance has supported bond-like equities and hurt growth stocks
• Equities are attractive relative to bonds, and within U.S. equities, growth stocks are even more attractive • Growth equities have the potential to shine as the demand for bond-like equity characteristics wanes and strong, dynamic fundamentals are rewarded
Page 19
Supplemental Information Evaluating Stock Market Returns
What Drives the Stock Market?
• “In the short run, the market is a voting machine, but in the long run, it is a weighing machine” (Ben Graham)
• Market return = EPS growth + dividend yield +/- P/E change
• If the starting P/E is reasonable (i.e. average) then the long-term return should approximately equal earnings growth plus the dividend yield
Source: FactSet, Robert Shiller. The second chart is in log.
Page 21
Earnings Growth Has Been Consistent
• 10-year real (inflation adjusted) EPS growth has been between 3% and 7% more than three-quarters of the time over the past 25 years, with the worst result still being slightly positive
10-yr Rolling Growth in S&P 500 Real EPS
8%
7%
6%
5%
4%
3%
2%
Real 10-Yr Rolling Growth
1%
0%
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Source: FactSet, S&P, and Alger estimates.
Page 22
Valuations are Very Important in Determining Future Returns
• There is a strong relationship between starting valuation and ensuing 10-year returns for both stocks and bonds • Current valuation corresponds to a high single-digit annualized 10-year return for stocks and a low-single digit 10-year return for bonds
Source: FactSet
Page 23
Valuation is Relatively In-line with Historical Averages and Cheap to Bonds
Valuation Measure
20-Year Median
Current
P/E
16.6
16.1
P/FCF
18.8
19.0
EV/EBITDA
12.1
12.2
30.0
S&P 500 12-Month NTM P/E
EV/Sales
2.3
2.3
P/B
2.6
2.8
25.0
E/P – BAA Yield
1.3
0.0
20.0
15.0
Average
10.0
5.0
0.0
Jul-91
Jul-02
Jul-13
Oct-88
Oct-99
Oct-10
Apr-94
Apr-05
Apr-16
Jan-86
Jun-92
Jan-97
Jun-03
Jan-08
Jun-14
Mar-95
Feb-96
Mar-06
Feb-07
Dec-86
Nov-87
Sep-89
Aug-90
Dec-97
Nov-98
Sep-00
Aug-01
Dec-08
Nov-09
Sep-11
Aug-12
May-93
May-04
May-15
Source: FactSet. The valuations presented above are based on consensus estimates for future 12-month periods. Actual valuations for such periods might be materially different than those shown.
Page 24
Global Valuation
• Emerging markets continue to trade at a historically large discount to developed markets based on NTM P/E
S&P 500
MSCI Europe
MSCI Japan
MSCI EM
25
23
21
19
17
15
13
P/E (NTM)
11
9
7
5
Jul-03
Jul-04
Jul-05
Jul-06
Jul-07
Jul-08
Jul-09
Jul-10
Jul-11
Jul-12
Jul-13
Jul-14
Jul-15
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
Jan-16
Source: FactSet
Page 25
Risk Relative to Time Horizon
• Equity returns look much less volatile over a longer time period than shorter time periods
‒ Using 20-year rolling returns, the relative standard deviation is actually lower for stocks than for bonds
60
Range of Stock and Bond Total Returns
52.3%
Stocks
50
Bonds
40
29.1%
28.6%
30
18.6%
17.9%
17.0%
20
12.8%
10.0%
10
6.5%
3.2%
0
Annual Total Returns
1.0%
1.8%
-1.7%
-2.4%
-5.1%
-10
-20
-30
-40
-37.0%
1-Year
5-Year Rolling
10-Year Rolling
20-Year Rolling
Source: Morningstar. Stock data is the S&P 500 total return and bond data is the Ibbotson Associates US IT Govt total return. The data spans 1950-2015.
Page 26
Disclosure
The views expressed are the views of Fred Alger Management, Inc. as of July 2016. Alger has used sources of information which it believes to be reliable; however, this publication is not intended to be and does not constitute investment advice. These views are subject to change at any time and they do not guarantee the future performance of the markets, any security, or any funds managed by Fred Alger Management, Inc. These views should not be considered a recommendation to purchase or sell securities. Individual securities or industries/sectors mentioned, if any, should be considered in the context of an overall portfolio and therefore reference to them should not be construed as a recommendation or offer to purchase or sell securities. References to or implications regarding the performance of an individual security or group of securities are not intended as an indication of the characteristics or performance of any specific sector, industry, security, group of securities, or a portfolio and are for illustrative purposes only. Risk Disclosures : Investing in the stock market involves gains and losses and may not be suitable for all investors. Growth stocks tend to be more volatile than other stocks as the prices of growth stocks tend to be higher in relation to their companies’ earnings and may be more sensitive to market, political and economic developments. Investing in foreign securities involves risks related to the political, social, and economic conditions of foreign countries, particularly emerging market countries. These risks may include political instability, exchange control regulations, expropriation, lack of comprehensive information, national policies restricting foreign investment, currency fluctuations, less liquidity, undiversified and immature economic structures, inflation and rapid fluctuations in inflation, withholding or other taxes, and operational risks. Special risks associated with investments in emerging country issuers include exposure to currency fluctuations, less liquidity, less developed or less efficient trading markets, lack of comprehensive company information, political instability and different auditing and legal standards. Foreign currencies are subject to risks caused by inflation, interest rates, budget deficits and low savings rates, political factors and government controls. Some of the countries may have restrictions that could limit the access to investment opportunities. The securities of issuers located in emerging markets can be more volatile and less liquid than those of issuers in more mature economies. Investing in emerging markets involves higher levels of risk, including increased information, market, and valuation risks, and may not be suitable for all investors.
Fred Alger Management, Inc. • 360 Park Avenue South, New York, NY 10010 • 800.992.3863 • www.alger.com
Page 27
Disclosure
The S&P 500 Index is an unmanaged index generally representative of the U.S. stock market without regard to company size. The Russell 1000® Growth Index is an unmanaged index designed to measure the performance of the largest 1000 companies in the Russell 3000 Index with higher price-to-book ratios and higher forecasted growth values. The Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Growth Index is an unmanaged index generally representative of common stocks designed to track performance of small-capitalization companies with greater than average growth orientation. The Russell 2000 Value Index is an unmanaged index generally representative of the small-cap value segment of the U.S. equity universe and measures the performance of Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 3000® Growth Index is an unmanaged index designed to measure the performance of those Russell 3000® Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell 3000 Value Index is an unmanaged index generally representative of stocks from the Russell 3000 Index with lower price-to-book ratios and lower expected growth rates. The indices presented are provided for illustrative purposes, reflect the reinvestment of dividends and do not assess fees and expenses that would have the effect of reducing returns. Investors cannot invest directly in any index. The index performance does not represent the returns of any portfolio advised by Fred Alger Management, Inc. and actual client results might differ materially than the indices shown. Note that past performance is no guarantee of future results. Comparison to a different index might have materially different results than those shown.
Fred Alger Management, Inc. • 360 Park Avenue South, New York, NY 10010 • 800.992.3863 • www.alger.com
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